Before the Fall: Disaster Myopia at the Fed

Like many other journalists who write about the Federal Reserve, I spent Friday morning reading the policy discussions that took place inside the central bank in 2007, as the global financial system teetered on the brink of collapse. Under a commendable policy of glasnost, introduced by Alan Greenspan and extended by Ben Bernanke, the Federal Open Market Committee, the Fed’s policy-making arm, now releases full transcripts of its deliberations after a delay of five years.

Covering eight meetings (four of which lasted two days each) and three emergency conference calls, the newly released transcripts run thousands of pages—a boon for future historians, as well as for reporters looking for nuggets to enliven their Twitter feeds. For anybody interested in what turned out to be the biggest financial crisis since the nineteen-thirties, it is fascinating to relive the Fed’s internal debates, as it grappled with the collapse of the market for subprime mortgage bonds and its ramifications for Wall Street and the broader economy.

But perhaps the most interesting thing about the transcripts is what they tell us about how policymakers thought before the full scale of the crisis became clear. Like the European politicians who blundered into war in 1914, most people at the Fed simply couldn’t conceive of the catastrophe that was to ensue. Lured into a false sense of security by more than two decades of economic prosperity, they suffered from what the economists Jack Guttentag and Richard Herring term “disaster myopia.”

It wasn’t as if Bernanke and the rest were ignorant about the downturn in the housing market, and how it was affecting some financial institutions that had a lot of subprime securities on their books. But the Fed policymakers, like their Edwardian forebears, believed they had things under control. The problems in the subprime market wouldn’t spill over into the broader economy, they thought. Indeed, the general view at the Fed (and in the markets) was that economic growth was picking up.

On June 27, 2007, at the start of a two-day meeting, Bill Dudley, who then ran the markets desk at the New York Fed (today, he is the institution’s president), reported that “market participants generally believe that the downside risks to growth have diminished”—a belief he did little to question. Nor did the Fed’s economic staff, which reported that it had raised its forecast for growth and reduced its forecast for unemployment. The staff’s “Greenbook” predicted that, by the end of 2008, the jobless rate would have dropped below five per cent. (The actual figure was 7.3 per cent.) When Bernanke turned the discussion over to his colleagues on the F.O.M.C., they also made upbeat comments, and so did he: “I agree with the general view around the table that, except for housing, the economy looks to be healthy.”

In retrospect, this was a bit like saying that, apart from the huge tumor in his abdomen, the patient was doing fine. But my point here is not to berate Bernanke, or his colleagues: they were merely parroting the collective wisdom of economists on Wall Street, in academia, and at other central banks. The interesting question is why they didn’t know better.

It wasn’t simply a matter not understanding the dangers lurking on Wall Street. During his presentation, Dudley pointed out that the subprime market was “still very unsettled,” with credit spreads rising fast, and that there was the danger that “forced selling could drive market prices down sharply, leading to lower marks for other portfolios of assets related to subprime mortgages. This, in turn, could lead to margin calls, investor redemptions, and further selling pressure in this market.”

This is exactly what happened six weeks later, when troubles at a couple of European financial institutions prompted a general panic, the subprime market froze up, and many financial institutions found themselves struggling to raise the short-term loans they needed to stay afloat. Indeed, Dudley correctly predicted many details of how such a calamity might unfold. High credit ratings would disguise the real risks attached to many securities, particularly “structured products”—C.D.O.s, C.L.O.s, and so on. Once investors started selling these constructs en masse, the pricing models that Wall Street firms used to value them would cease to work. Correlations between supposedly distinct securities would increase—their prices would all fall at the same time—and the safety they afforded investors could “evaporate quickly.”

Still, Dudley, his boss, Timothy Geithner, and Donald Kohn, the vice-chairman of the Fed, all played down the dangers of the subprime market. It was left to Richard Fisher, the president of the Dallas Fed, and a former Wall Street banker and hedge-fund manager, to express more concern. Comparing what was happening to previous market disturbances, such as the 1998 collapse of Long-Term Capital Management, he said, “This has broader dimensions than those we had before. If you look at the growth rate of these instruments…it has been a straight upcurve. The numbers are quite huge.” And he went on: “I would like to understand this better, and I hope that we all understand it very well in case a negative scenario obtains.”

What explains the disaster myopia that afflicted Bernanke, Geithner, and their colleagues, and that Fisher showed at least an inkling of overcoming? Clearly, history played a big role. From the stock-market crash of 1987 to L.T.C.M. to the bursting of the dot-com bubble, the Fed had been largely successful in preventing problems on Wall Street from spreading to the rest of the economy. Why not this time? In terms of behavioral economics, the Fed policymakers succumbed to the “representative heuristic”—the tendency to assume that the future will look like the past.

Second, many of them were defrocked academics relying on a theoretical framework—modern macroeconomics—that paid little attention to institutional features, such as developments in the banking system. According to the theories that Bernanke helped develop during his days in academia, as long as the Fed carefully adjusted interest rates to keep inflation under control, and also kept an eye on the money supply, it couldn’t go too wrong. In terms of maintaining a healthy rate of economic growth, the things that mattered most were tangible inputs and outputs: the labor supply, unemployment, productivity growth, and inflation. The financial sector was merely a “veil”—except, in this case, the veil almost strangled its wearer.

Finally, folks at the Fed may have been reluctant to recognize their own mistakes. For several years, they had kept interest rates artificially low to stimulate the economy. In terms of G.D.P. growth, the results had been pretty modest, but the impact on the housing market had been dramatic. Many parts of the country had experienced an unprecedented bubble. Tens of millions of homeowners were delighted. For a time, Bernanke and his colleagues were lionized.

By the summer of 2007, the party was over, and the inevitable hangover was beginning. It is really any wonder that the Fed was disinclined to consider such an outcome?